Financial Risk Manager Part 1

Explanation

The Fama-French three-factor model differs from the CAPM in that it adds two additional factors beyond the market risk premium:

1. SMB (Small Minus Big) - Captures the size effect (small-cap stocks tend to outperform large-cap stocks)
2. HML (High Minus Low) - Captures the value effect (value stocks tend to outperform growth stocks)

Key Differences:

• CAPM uses only one factor: market risk premium (beta)
• Fama-French 3-factor model uses three factors: market risk premium, size factor (SMB), and value factor (HML)

Why Option C is Correct:

• The Fama-French model specifically adds factors related to firm size (SMB) and book-to-market ratio (HML), which are not macroeconomic variables
• This explains why small-cap and value stocks have historically shown different return patterns than what CAPM would predict

Why Options A and B are Incorrect:

• The Fama-French model does NOT incorporate macroeconomic variables like inflation or GDP growth
• These macroeconomic variables are typically used in other models like the Arbitrage Pricing Theory (APT)
• The Fama-French factors are based on empirical anomalies in stock returns, not macroeconomic indicators

For small-cap value stocks specifically, the Fama-French model would likely show positive loadings on both SMB (small size) and HML (value) factors, explaining their historical outperformance that CAPM cannot capture.